Welcome to what I genuinely believe will be one of the most valuable lectures of your entire business education. I'm not exaggerating when I say that. Today, we're covering chapter 1, managerial accounting and cost concepts. And by the end of these 75 minutes, you'll understand something that most business professionals take years to truly grasp, if they ever do at all. Before we dive in, let me share something that just happened last week that perfectly illustrates why this matters. I got an email from Jennifer, one of my students from three years ago. She's now a senior analyst at Goldman Sachs making $95,000 base salary plus bonuses that nearly double that. She wrote, "Doctor Fulmore, I use what you taught in this exact lecture every single day. My managing director was shocked that I understood cost structures better than the MBAs on our team who had five years more experience. Last month, I identified a cost classification error in a client's analysis that would have led to a $50 million mistake. That single catch got me promoted two levels ahead of schedule. That could be you in three years, but it starts with understanding what we're covering today. You see, today's lecture will cover six major learning objectives that form the foundation of everything else we'll learn this semester and more importantly everything you'll need in your career. I know accounting can seem intimidating. I remember sitting where you are terrified of debits and credits, wondering if I'd chosen the wrong major. But here's the secret I discovered. If you can manage your own budget, if you can decide whether to buy or rent textbooks, if you can figure out whether that spring break trip is worth it, you already have the intuition for cost accounting. We're just going to formalize what you already know and add some powerful tools that companies pay consultants millions of dollars to apply. Let me start with a question that'll blow your mind and show you exactly why understanding costs matters more than you think. How many of you have Netflix? Keep your hands up. Add Spotify still up if you have both. Disney Plus, Hulu, Apple Music. Now, here's what's fascinating. You're probably spending somewhere between $300 and $500 a year on these subscriptions, which is more than your grandparents spent on all entertainment combined. yet you're getting infinitely more value. But did you know that Netflix spends only three cents to stream a movie to you, yet charges you $15.99 a month? Spotify streams a song to you for 0.001, but charges $9.99 monthly. Where does the rest of that money go? That's what managerial accounting answers. And understanding this difference between what something costs to deliver versus what companies charge is the foundation of all business strategy. But here's why this really matters to your life right now today in this classroom. The average starting salary for someone who truly understands cost accounting at the big four firms, Deote, PWC, EY, and KPMG, is between $75,000 and $85,000, plus signing bonuses that can reach $10,000. Plus, you get your CPA exam fees covered, plus 3 weeks vacation, plus benefits worth another $15,000. McKenzie Bane and Boston Consulting Group pay even more starting at $95,000 to $110,000 for undergrads. They're not paying for your ability to memorize formulas or prepare journal entries. They're paying for your ability to think about costs the way we're going to teach you today. To see patterns others miss. To identify opportunities for profit improvement. to understand why some businesses succeed while others fail despite having great products. Let me tell you about a real scenario from last year's campus recruiting that shows exactly what I mean. A student was in a final round interview with Amazon for their finance rotation program. Starting salary $88,000 plus stock options worth potentially hundreds of thousands. The interviewer asked, "If Amazon Prime costs $139 per year and we ship an average of 50 packages per Prime member, what's our break even shipping cost per package?" The student who got the job immediately recognized this as a simple cost behavior problem. Fixed subscription revenue divided by variable package volume. Exactly what we're covering today. She said $2.78 per package. Then went further to explain how this creates a contribution margin framework where Amazon actually wants you to order more because they've already covered their fixed costs. The student who didn't get the job tried to guess, mumbled something about economies of scale, and lost a life-changing opportunity. Don't be the guesser. Be the one who knows. Before we jump into the technical concepts, let me tell you a story that shows why cost accounting literally changed the world and created the modern economy we live in today. In 1913, Henry Ford was struggling with a problem that seemed unsolvable. His Model T was the most popular car in America. People were lining up to buy them, yet he wasn't making much money and couldn't figure out why. Sales were great. The product was revolutionary, but profits were disappointing. Then he hired a brilliant accountant named Norville Hawkins, who did something that had never been done before in manufacturing. He tracked every single cost down to the penny for every car component, every minute of labor, every drop of paint, every bolt and screw. This was revolutionary because before this, companies just knew their total costs and total revenues, but had no idea which products, which customers, which processes were actually profitable. Hawkins discovered something shocking that changed business forever. Ford was losing $2 on every replacement part they sold, but making $100 profit on each new car. The parts business was subsidizing competitors who bought Ford parts to repair their cars. This led to Ford's famous decision, make cars that never break down, forcing competitors to handle their own parts. Ford started using venadium steel, which was stronger and lasted longer even though it cost more initially. His competitors were counting on repair profits using inferior materials. But Ford eliminated that need. By 1925, Ford owned 50% of the global car market and his Model T had become so reliable that some are still running today over 100 years later. All because of cost accounting insights that his competitors didn't have. But here's my favorite historical fact that'll help you remember why we classify costs into categories. The term bean counter for accountants actually comes from the 1920s when HJ Hines food company literally had accountants counting beans to figure out the cost per can. They needed to know how many beans in a can, cost per bean, cost of the can, cost of the label, cost of the cooking time. One junior accountant named Frederick Johnson discovered they were losing two cents on every can of beans but making 12 cents profit on ketchup. He recommended immediately pivoting the entire business strategy toward condiments. The board thought he was crazy. Hines was known for beans, but the numbers didn't lie. Hines shifted focus to ketchup and that junior accountant became CFO 5 years later, then CEO after that. Today, Hines sells 650 million bottles of ketchup annually, and hardly anyone knows they still make beans. Cost accounting isn't just about numbers. It's about seeing opportunities others miss. About having the courage to follow what the data tells you, even when it contradicts conventional wisdom. Now, let's clear up the biggest confusion students have. Something that even many business professionals don't fully understand. There are two completely different types of accounting. And they're as different as Instagram and Tik Tok, serving different purposes for different audiences with different rules. Financial accounting is like Instagram. It's the polished, curated, public face you show the world where everything has to be perfect. follow strict rules called GAAP standards. And it's all about showcasing what already happened in the best possible light. When Apple announces they made $365 billion in revenue and $97 billion in profit, that's financial accounting. The Instagram worthy highlight reel designed for investors, creditors, and regulators who are outside the company looking in. It's backward-looking, historical, and has to follow rules so strict that companies spend millions just ensuring compliance. Every public company's financial statements look basically the same because they all follow the same rules, just like how everyone's Instagram profile follows the same basic format. Managerial accounting, on the other hand, is like your Tik Tok drafts folder. It's the behindthe-scenes messy real work where actual decisions get made, where you try different things, where you experiment and fail and try again. There are no rules except be useful for making decisions. It's all about the future, not the past. And it's only for internal eyes. When Tim Cook is deciding whether to manufacture the iPhone 16 in China, India, or Vietnam, he's not looking at pretty financial statements. designed for Wall Street. He's looking at detailed cost analyses that would never see the light of day outside Apple's boardroom. Spreadsheets comparing labor costs, shipping times, quality issues, political risks, tariff implications, and hundreds of other factors that don't appear in public financials. Here's a real example that shows the dramatic difference between these two types of accounting. In 2019, Disney's financial accounting showed they made 11 billion in profit. That's what investors saw. That's what made headlines. That's what drove the stock price up. But internally, their managerial accounting showed that Disney Plus was losing $300 per subscriber in the first year when you factored in content creation costs, technology, infrastructure, and marketing. Financial accounting said record profits because those Disney Plus costs were capitalized and wouldn't hit the income statement for years. Managerial accounting said we're bleeding cash on streaming. But our models show it'll pay off in 3 years when we hit 100 million subscribers. Both were true, just different perspectives for different purposes. By the way, Disney Plus hit 100 million subscribers in 16 months, not 3 years, and is now profitable. The managerial accountants were actually too conservative. The key difference to remember for your career, financial accounting asks, "What happened?" While managerial accounting asks, "What should we do?" One looks backward with perfect hindsight. One looks forward with uncertainty. One follows rules set by regulators. One follows logic and business sense. One is for external users who need comparability. One is for internal managers who need actionable insights. You need both to run a business, but today we're focusing on the one that will actually help you make business decisions that create value. Here's something that will revolutionize how you think about costs and make you realize why accountants are actually strategic thinkers. Not just number crunchers. The same cost, literally the same dollar amount, the same transaction gets classified five different ways depending on what decision you're making or what question you're trying to answer. It's like how your smartphone is simultaneously a phone for calling your mom, a camera for Instagram, a gaming device for killing time between classes, a wallet for Venmo payments, and a social media machine for Tik Tok scrolling. Same device, different purposes, and you think about it differently depending on what you're using it for. Let me introduce you to AFPDB, accounting friends party during break. your memory device for the five purposes of cost classification that you'll use for the rest of your career. First, a for assigning costs to cost objects, which means figuring out what things actually cost. When Chipotle wants to know how much that burrito bowl you just ordered costs them to make, they're assigning costs. The rice, beans, chicken, guacamole. Yes, they know exactly why guac is extra. the container, the fork, even the 48 seconds of labor it took to assemble it. Second, F for financial statement preparation, where that same burrito's cost becomes inventory on the balance sheet until the moment you buy it, then transforms into cost of goods sold on the income statement. Third P for predicting cost behavior because Chipotle needs to know if selling twice as many burritos means exactly twice the cost. It doesn't. Their rent stays the same whether they sell 100 or 1,000 burritos. Fourth D for decision making. Like when Chipotle debates whether to add quesadillas to the menu, they need to know the differential costs of new equipment, training, ingredients, and complexity versus the incremental revenue. Fifth, B for budgeting and planning, where they forecast how much cost will be next quarter if they sell 20% more burritos due to their new marketing campaign. Let's make this incredibly real with Netflix, a company you interact with daily but probably never think about from a cost perspective. The cost of streaming Stranger Things to you right now at this very moment has five different classifications depending on the question being asked. For assigning cost to cost objects, it's a direct cost to your specific account because Netflix can track exactly how much bandwidth you're using, about 0 03 per hour of HD streaming. For financial statement preparation, the show itself is part of their content assets being advertised over its expected viewing life. They paid $200 million to produce all seasons, but expense it over several years. For predicting cost behavior, streaming is mostly fixed. They already paid for the content and servers with small variable components. the bandwidth that scales with viewership. For decision makingaking, they're constantly asking if keeping this show is worth the licensing fee versus the subscriber retention it drives. They know exactly how many people would cancel without Stranger Things. for budgeting and planning. They're modeling next year's content costs based on viewing patterns, knowing that successful shows like Stranger Things let them take risks on experimental content. Same show, same cost. Five completely different ways to think about it. Each one crucial for different business decisions. Let's talk about one of the most fundamental concepts in cost accounting that trips up even experienced managers and definitely shows up on every exam and job interview. The distinction between direct and indirect costs, which all comes down to one key word, traceability. Can you trace this cost to a specific cost object easily and economically? If yes, it's direct, like following a GPS route straight to your destination. If no, it's indirect, like trying to figure out how much of the campus Wi-Fi you personally use. Simple concept, but the applications get interesting and sometimes counterintuitive. And mastering this will make you invaluable in any organization because most people get it wrong. Think about a Tesla Model 3 rolling off the assembly line in Fremont, California. a specific car that maybe you'll own someday. The battery pack that goes into that specific car. Direct cost. We can literally point to it, touch it, put a serial number on it. It costs Tesla exactly $4,500. And there's precisely one in each car. No ambiguity whatsoever. The assembly worker who installs that battery earning $30 per hour and taking exactly 30 minutes. Also direct, we can track their time to that specific car using Tesla's manufacturing execution system that logs every operation. That's $15 of direct labor traced to your specific Model 3. But what about Elon Musk's compensation package? Can we trace his work to that specific Model 3? Obviously not. His strategic decisions, his tweets that move the stock price, his engineering insights benefit all Tesla products equally. So it's indirect to any specific car. The Gigafacto's monthly electricity bill of $2 million. Indirect, it powers the whole factory, the assembly lines, the lights, the air conditioning, the employee break rooms, not just the production of one car. Here's where students always get confused, and I see this mistake on 60% of exams. So, pay attention because this will save you points and maybe get you a job. Just because you can calculate a cost per unit through simple division doesn't make it a direct cost. This is the most common error in cost accounting. Watch this example carefully. Our university president makes $500,000 a year and we have 10,000 students. So that's $50 per student, right? I can calculate it, so it must be direct. Absolutely wrong. That's still an indirect cost because we can't trace the president's work to you specifically. The president doesn't spend exactly 0.01% of their time specifically on your individual education. They make decisions that affect all students simultaneously. hiring faculty, setting strategy, fundraising for new buildings. This is called the allocation fallacy, and it's one of the biggest and most expensive mistakes in business. Let me give you a real world example that cost a company millions and shows why this distinction matters so much. In 2018, a major airline that I won't name, but rhymes with United tried to figure out the cost of flying one passenger from Dallas to New York. Some junior analyst decided fuel was a direct cost to each passenger. Makes sense, right? More passengers, more weight, more fuel burned. Wrong. The plane flies whether there's one passenger or 200. That flight burns roughly the same 5,000 gallons of jet fuel regardless. The fuel is direct to the flight as a whole, but indirect to any specific passenger. They made pricing decisions based on this error, thinking each passenger cost them $50 in fuel and started charging fees based on this miscalculation. They lost $50 million in six months before a smart young analyst, probably someone who took this class, caught the mistake. The fuel cost per passenger only makes sense as an allocation for analysis, not as a direct cost for decision-m. Now let's talk about a special type of indirect cost called common costs that are absolutely everywhere in modern business and especially relevant in today's sharing economy. These are costs that support multiple cost objects simultaneously and can't be separated or traced to individual objects even if you wanted to. They're truly common to all. Think of it like your apartment's Wi-Fi that you share with three roommates. The Wi-Fi router provides internet to everyone simultaneously. You can't say this portion of Wi-Fi is mine or I'm using 25% of the Wi-Fi right now. It's common to all roommates benefiting everyone at the same time. You might split the bill four ways, but that's just an arbitrary allocation for fairness, not because each person actually uses exactly 25%. In business, common costs are everywhere and understanding them is crucial for making good decisions. The CEO's salary is common to all products. When Satcha Nadella makes a strategic decision at Microsoft, it benefits Windows, Office, Azure, Xbox, and LinkedIn simultaneously. You can't say $1 million of his salary goes to Excel development. Amazon Web Services AWS infrastructure is common to all Amazon services. Prime Video, shopping, music, Alexa. Everything runs on the same massive server farms. The electricity powering those servers, the security guards protecting them, the engineers maintaining them. All common costs. The security guard at Apple's headquarters provides security for iPhone development, iPad development, Mac development. Apple Watch, AirPods, all simultaneously. That guard doesn't spend 40% of their time protecting iPhone secrets and 20% protecting iPad secrets. They protect the entire facility. Here's a practical example you'll face in your career, probably within your first year of working. You're at Deote or PWC consulting for multiple clients. Your laptop that costs the firm $2,000. your Microsoft Office license at $300 per year, your desk space that costs $500 per month, your corporate cell phone at $100 per month. These are common costs across all your clients, deote bills, clients, $300 per hour for your time. But how much of your laptop cost should each client bear? If you work on five clients this month, does each get charged $400 for the laptop? What if you spent 80% of your time on one client and 5% each on the others? Most firms just spread common costs evenly or ignore them in pricing. But smart firms use activity-based costing to allocate based on usage patterns, something we'll cover in chapter 4. For now, just remember that common costs are like the overhead lights in this classroom. They benefit everyone simultaneously, and any allocation to individual students is arbitrary. The electricity powering these lights cost the same, whether there's one student or 50. And trying to trace the exact amount of light you're personally receiving would be impossible and pointless. Let's dive deep into the first of the three manufacturing cost categories. And this is where business gets tangible where you can actually touch and feel what we're talking about. Direct materials. These are the raw materials that become an integral physical part of the finished product and can be conveniently traced to specific units. The key words being integral part and conveniently traced because both conditions must be met for a cost to be classified as direct material. Pick up your iPhone or Samsung right now. Seriously, take it out and look at it. Every single physical component you can identify is direct material to Apple or Samsung. And the numbers are fascinating when you understand what you're actually holding. The screen you're looking at direct material that costs Apple exactly $38 for the iPhone 15 Pro. They buy millions from Samsung Display and LG Display. And they can trace each screen to each phone through serial numbers. The A17 Pro chip that makes everything work. Direct material at $45 per chip. Manufactured by TSMC in Taiwan exclusively for Apple. the titanium frame that makes it feel premium. Direct material at $52, which is why the Pro models cost so much more than the regular ones with aluminum frames at just $8. the camera system that you use for Instagram. Direct material at $28 for the Pro models three camera array. The battery that you're probably worried about right now, direct material at $12. Add it all up with about 40 other components and the total direct materials in your $1,200 iPhone cost Apple about $210. That's it. The physical stuff you can touch, the actual tangible product you hold in your hand costs less than 20% of what you paid. But here's where it gets tricky and where most people misunderstand direct materials leading to costly business mistakes. What about the 50 tiny screws holding your phone together? Technically, they're materials in the phone. You could disassemble it and find them, but each screw costs 1,000th of a dollar. Is it worth tracking 50 screws separately at a penny per hundred? Is it worth having someone count screws, track screw inventory, allocate screw costs? Absolutely not. So, even though they're technically direct materials, we treat them as indirect because it's not convenient or economical to trace them. This is called the materiality concept. If something is too small to matter for decision-m, we simplify our tracking. It's like when you're cooking dinner. You don't track individual grains of salt, even though they're technically ingredients in your food. You might track the chicken breast, the vegetables, the pasta, but not the pinch of salt or drop of oil. Fun fact from history that shows how important direct materials tracking can be. In World War II, the US government required every manufacturer to track every ounce of aluminum as direct material for aircraft production because aluminum was scarce and critical for the war effort. They discovered that Boeing was wasting 15% of aluminum in their B17 bomber production process through inefficient cutting patterns while Lockheed only wasted 3% on their P38 Lightning. This single cost accounting discovery led to Boeing redesigning their entire manufacturing process, saving enough aluminum to build an extra 2,000 bombers. Historians estimate this shortened the war by 3 months because those extra bombers accelerated the air campaign over Europe. That's the power of understanding and tracking direct materials. It can literally change history. Direct labor is absolutely fascinating because we're witnessing its disappearance in real time. And understanding this transformation will help you understand the massive economic shifts happening in our society. Direct labor consists of labor costs that can be easily traced to individual units of product. Basically, the wages of people who actually physically touch and build the product. But here's the mind-blowing statistic. In 1950, direct labor was 40% of a typical manufactured products cost. Today, it's often less than 5%, sometimes less than 1%. Yet understanding it remains crucial because it helps you comprehend the massive shift from manufacturing economies to knowledge economies, from bluecollar to white collar work, from human labor to automation and AI. Let's look at something you've probably consumed this week. A Chipotle burrito bowl. When the employee behind the counter assembles your bowl, scooping rice, beans, meat, salsa, cheese, lettuce, and yes, charging you extra for guacamole. That's direct labor in action. Chipotle has tracked this obsessively using time motion studies and found it takes exactly 48 seconds of labor to make one bowl when the employee is working efficiently. At $15 per hour, which is roughly Chipotle's average wage, that's exactly 20 cents of direct labor. $15 divided by 60 minutes equals 25 cents per minute time 0.8 minutes equals 20. The person literally touching your food, customizing it to your exact specifications, using their judgment about portion sizes, cost Chipotle 20s out of the $11 you paid. Direct labor is less than 2% of the price. Now, think about what this means. The human being making your food, the only part of the process that requires judgment, creativity, and customer interaction, is the cheapest component. Now, here's where it gets interesting for your career prospects. Companies are desperately trying to reduce direct labor, not necessarily because they hate workers, but because direct labor is variable. More products mean more labor costs, and humans are inconsistent. need breaks, call in sick, and require training. Tesla's Gigafactory in Nevada employs 7,000 people, but only 500 are direct labor actually touching cars. The other 6,500 engineers designing robots, programmers optimizing systems, managers coordinating operations, quality control specialists monitoring output, maintenance technicians keeping machines running, all indirect labor. This shift from direct to indirect labor is why manufacturing jobs have fundamentally changed. The guy bolting wheels on cars for $25 an hour is being replaced by a woman programming the robot that bolts wheels for $150,000 a year. One robot replaces 10 workers but requires two engineers to maintain it. Fewer jobs but higher paying ones. But here's the paradox that'll help you in interviews and strategic thinking. Companies with the lowest direct labor often have the highest profits, but also the highest risk. Why? Because if you've replaced all your direct labor with machines, which are fixed costs, you need huge volume to be profitable. This is why Tesla almost went bankrupt three times between 2008 and 2018. Their low direct labor meant they needed to sell hundreds of thousands of cars to cover their massive fixed costs. When they were only selling 50,000 cars per year, they were bleeding cash. But now that they're selling 2 million cars annually, their low direct labor gives them industry-leading margins. Understanding this relationship between direct labor, automation, and business risk is what separates strategic thinkers from simple number crunchers. This is where the real money is hidden, where fortunes are made or lost, and where most businesses either succeed spectacularly or fail miserably. manufacturing overhead or Mo, which includes absolutely all manufacturing costs except direct materials and direct labor. Everything needed to run the factory that you can't trace to specific products. Here's the shocking truth that most business students don't realize until they're working. In most modern manufacturing, Mo is 60 to 80% of total product cost. dwarfing both direct materials and direct labor combined. This is the complete opposite of how manufacturing worked 100 years ago when direct labor was dominant and it's why modern cost accounting is so critical. The biggest costs are the hardest to see and control. Let's break down Mo into three categories to understand where all this money goes. First, indirect materials. things like glue, lubricants, cleaning supplies, small screws, tape, packaging materials that aren't traced to specific products. Gorilla glue is used in making Nike shoes to bond the sole to the upper. But can you trace the exact amount of glue to your specific Air Jordans? You could theoretically weigh the glue in each shoe, but it would cost more to track than the glue itself is worth. Boeing uses millions of rivets in each 787 Dreamlininer, but tracking each 10-cent rivet to specific planes would be insane. Second, indirect labor, supervisors, maintenance workers, quality inspectors, security guards, janitors, materials handlers, production schedulers. The quality inspector at the iPhone factory in China checks hundreds of phones per day, looking for defects, ensuring standards. But can you trace their salary to your specific phone? No. Their work benefits all phones equally. The maintenance technician who keeps the million-doll machines running prevents problems across thousands of units. Third, other mo. This is the big one. factory rent or depreciation, equipment depreciation, utilities, insurance, property taxes, repairs and maintenance, factory supplies, small tools. Tesla's Gigafactory uses $100,000 of electricity every single day. Can you trace the exact kilowatts used to manufacture one specific Model 3? Technically possible with enough sensors, but completely impractical and unnecessary for decisionm. Here's a real example that shows why Mo matters so much and why ignoring it leads to disaster. In 2019, Boeing was building the 737 Max, their newest version of the world's most popular airliner. Their direct materials were $30 million per plane. Engines, fuselage, wings, avionics, seats, everything you can see and touch. Direct labor was only $2 million because modern aircraft are assembled more than manufactured with major components coming from suppliers, but Mo was $45 million per plane. This included engineering support to solve technical problems, testing facilities to ensure safety, regulatory compliance costs to satisfy the FAA and international authorities, factory depreciation on billions of dollars of equipment, quality systems to prevent defects, and hundreds of other costs necessary to build planes, but not traceable to specific aircraft. when they had to ground the entire 737 Max fleet after two crashes. They still had all that Mo but zero production. The factory still needed electricity. The engineers still got paid. The equipment still depreciated. The insurance still came due. They lost $18 billion in two years, mostly because Mo doesn't go away when production stops. It's like paying rent on an apartment you can't live in. The career insight here is incredibly powerful and could accelerate your career by years if you understand it. If you want to make yourself invaluable at any company, become the person who understands and can reduce Mo. I had a student named Sarah who joined Intel right after graduation. She discovered they were allocating IT support costs, part of Mo, to production departments based on square footage of department space. She suggested allocating based on number of IT tickets instead, reasoning that actual IT usage was a better cost driver than floor space. This one change saved Intel $3 million annually because it incentivized departments to solve their own problems rather than calling it for everything. She got promoted twice in 18 months and is now making $140,000 at age 25. That could be you if you master this concept and learn to see the opportunities hidden in overhead. Here's a concept that appears on literally every CPA exam, most consulting case interviews, and surprisingly in real strategic decisions at companies from Apple to Tesla. The two ways we combine manufacturing costs for different analytical purposes. Prime costs equal direct materials plus direct labor. Think of these as the primary inputs you can see and touch. the costs that are prime or first in importance for pricing decisions. Conversion costs equal direct labor plus manufacturing overhead representing everything needed to convert raw materials into finished products. The transformation process itself. What makes this interesting is that direct labor appears in both categories. It's the bridge between materials and transformation. Which is why even though direct labor is shrinking in importance, it remains conceptually central to manufacturing. Let me make this crystal clear with a Tesla Model 3 example that shows how these concepts drive real business decisions. The battery cells from Panasonic and the aluminum body panels are just expensive material sitting in a warehouse until Tesla converts them into a car that someone actually wants to buy. Prime costs would be the $4,500 battery pack plus $1,800 in other direct materials plus $150 of direct labor from the workers who actually assemble the car. The visible traceable inputs totaling $6,450 that you could theoretically buy yourself if you wanted to build your own car. Conversion costs would be that same $150 of direct labor plus $8,000 of factory overhead, including robot depreciation, factory electricity, quality testing, paint booth operation, and hundreds of other processes. Everything needed to transform those parts into a functioning vehicle, totaling $8,150. Notice how direct labor of $150 appears in both categories. It's simultaneously a prime input and part of the conversion process, which is why accountants include it in both groupings. Why should you care about this seemingly academic distinction? Because different industries focus on different metrics, and knowing which one matters shows you understand the business deeply. Tech hardware companies like Apple obsess over prime costs because materials are their biggest expense. The components in an iPhone cost more than everything else combined. So they negotiate ruthlessly with suppliers and redesign products to use cheaper materials. Service companies focus on conversion costs because they're basically converting labor and overhead into value with minimal materials. A consulting firm's prime costs are almost zero, but their conversion costs are enormous. When you're in an interview and they ask about cost structure, knowing whether to emphasize prime or conversion costs shows sophisticated understanding. A student last year interviewed with both Apple and Boeing on the same day at our career fair. For Apple, she emphasized prime costs, talking about component sourcing, supplier negotiations, and material substitution strategies because she knew Apple spends billions on iPhone components. for Boeing. She emphasized conversion costs, discussing the massive overhead required for aerospace safety compliance, testing, and certification because she understood that aerospace is about converting aluminum into certified flying machines. She got offers from both companies with starting salaries over $90,000 because she demonstrated deep understanding of their different cost structures. This is the kind of strategic thinking that transforms accounting knowledge into career success. Now we leave the factory floor and enter the rest of the business world where actually most costs live and where most of you will spend your careers. Non-manufacturing costs are all costs not associated with making products. And here's the critical point that will be on every exam. They're always, always, always period costs, meaning they're expensed immediately on the income statement, never included in inventory, never sitting on the balance sheet waiting to become COGS. These fall into two main categories that you'll see in every company, from Google to your local coffee shop, from Tesla to your university. First, selling costs include everything needed to get the product to customers and convince them to buy it. And these divide into two important subcategories. Order getting costs are about creating demand and include advertising. Nike spent $3.7 billion last year just on advertising, more than many. Company's total revenue sales salaries and commissions. Pharmaceutical sales reps make $100,000. Base plus commissions that can double that. Marketing campaigns. Red Bull sponsors everything extreme from Space Jumps to F1 racing spending $2 billion annually. Social media influencers. Fashion Nova pays Cardi B $500,000 per Instagram post. And trade shows. CES in Las Vegas costs tech companies millions just to attend. Order filling costs are about delivering what's sold and includes shipping. Amazon spends $80 billion annually on shipping, more than NASA's entire budget. Warehousing. Walmart has 150 distribution centers costing billions to operate. Delivery vehicles. FedEx owns 200,000 vehicles. And customer service. Apple's Genius Bar costs millions to operate, but drives sales through customer satisfaction. Second, administrative costs include everything needed to run the company that isn't making or selling products. Executive compensation. Tim Cook made $99 million last year. Elon Musk's package could reach $55 billion. Accounting and legal. PWC charges Apple $50 million annually just for auditing their financial statements. corporate headquarters. Google's Mountain View campus costs $1 billion yearly to operate, HR and recruiting. Goldman Sachs spends $500 million annually on recruiting, including your campus career fairs, and general corporate expenses like insurance, IT systems, and corporate jets. Fun fact that shows the scale. Amazon's second headquarters in Arlington. Virginia will cost $2.5 billion just to build, plus $200 million annually to operate. All administrative cost that will be depreciated over 40 years, but never included in the cost of any product they sell. Here's the critical strategic insight for your career that most people miss. Modern companies are intentionally shifting from manufacturing costs to non-manufacturing costs because it makes them more flexible and scalable. Nike owns almost no factories. They outsource all production to companies in Vietnam and China, converting fixed manufacturing overhead to variable purchase costs and focus instead on design and marketing, which are non-manufacturing costs. This is why Nike's profit margin is 45%. While traditional shoe manufacturers like Reebok struggle to hit 10%. Apple doesn't manufacture iPhones. Foxcon does. Apple focuses on design, administrative, and marketing selling, which is why they capture most of the profit despite not actually making anything. When you understand this shift from manufacturing to non-manufacturing focus, you understand why modern business looks so different from your grandparents economy and why your career will likely be in non-manufacturing functions even if you work for a manufacturing company. This is probably the single most important distinction for your exams, your career, and understanding how businesses can manipulate profits legally. the difference between product and period costs. Product costs are like passengers on a cruise ship. They stay with the product through its entire journey until it reaches its final destination, the customer, enjoying the ride as assets on the balance sheet before finally becoming expenses on the income statement. These costs become inventory on the balance sheet and only become expenses. cost of goods sold when the product is sold. And this timing difference can dramatically affect reported profits, stock prices, and executive bonuses. In a manufacturing company, product costs include all manufacturing costs, every penny of direct materials, direct labor, and manufacturing overhead. Here's the journey that shows why timing matters so much. In January, Tesla spends $12,000 to manufacture a Model 3 in their Fremont factory. DM $4,500 for batteries and materials. DL $150 for the assembly workers. MO $7,350 for factory overhead like robots, electricity, and supervisors. From February through May, that $12,000 sits as inventory on Tesla's balance sheet, reported as a current asset, just like cash or accounts receivable. It's not an expense yet. Tesla has spent the cash. The car is built, but accounting rules say it's not an expense until sold. In June, a customer finally buys it for $45,000. Now that $12,000 becomes cost of goods sold on the income statement and Tesla reports $33,000 in gross profit. $45,000 revenue minus $12,000 COGS. But notice the timing gap. Costs incurred in January don't hit the income statement until June, 5 months later. This timing difference creates massive opportunities and risks that affect everything from stock prices to CEO compensation. Here's a real example that cost investors billions. In Q4 2018, Tesla produced 90,000 cars in a massive endofear push that Elon Musk called delivery logistics hell. They couldn't deliver about 20,000 cars before December 31st due to transportation bottlenecks, not enough carriers, not enough delivery staff. Some customers couldn't take delivery during holidays. Those 20,000 cars sat as inventory at year end. The production costs didn't hit their income statement, making Q4 2018 look more profitable than reality. Analysts who understood product cost timing saw through this and warned that Q1 2019 would be hit with those costs when the cars were finally delivered. Tesla stock dropped 15% in January when investors realized the great Q4 was just timing, not operational improvement. For merchandising companies like Target, Best Buy, or Amazon, when selling others products, not AWS or Prime Video, product costs are simpler, but still crucial. Just the purchase price plus freight in. Buy a TV from Samsung for $400. Pay $20 shipping to get it to your warehouse. Sell it for $600. The $420 total is product cost, sitting as inventory until sold. But here's what's genius about Amazon's model. They often sell products before paying suppliers called a negative cash conversion cycle. They might sell that TV to you today, charge your credit card immediately, but not pay Samsung for 60 days. This means they get cash from customers before the product cost even becomes their expense. Essentially getting free loans from suppliers to fund their growth. This is why understanding product cost timing is worth millions in working capital management. It's not just accounting. It's strategic finance that determines whether companies survive or thrive. Period costs are the complete opposite of product costs. They're like Snapchat messages or Instagram stories that disappear immediately expensed in the period incurred regardless of what's happening with production or sales. These costs never become inventory, never sit on the balance sheet as assets waiting for their moment, never get to ride along with products. They go straight to the income statement like a express elevator to expense land. They're the costs of running a business that aren't about making products. And if it's not directly involved in manufacturing, it's almost certainly a period cost. All selling and administrative expenses are period costs. No exceptions, no debate, no gray area. Think about Netflix's massive content acquisition spending. When they pay $100 million for the rights to stream friends, you might think that's a product cost. After all, content is literally what Netflix sells to subscribers. But no, under traditional accounting, it would be a period cost. Though Netflix actually uses creative accounting to capitalize it as a content asset, which the SEC allows because streaming economics are different from traditional businesses. Marketing is always a period cost, even when it drives sales for years. When Nike pays LeBron James $32 million per year for endorsement, that's a period cost expensed immediately, even though his endorsement will sell shoes for the next decade. When Coca-Cola spends $4 billion annually on advertising, maintaining their brand value that's worth $80 billion, it's still period cost. Here's the trap that gets students every single time on exams. And I mean every time. Location doesn't determine classification. Function does. The factory supervisor's salary. Product cost because they're involved in production even though they're management. The sales manager visiting the factory for a product launch meeting. Still period cost because their function is selling, not producing even though they're physically in the factory. Depreciation on factory equipment. Product cost because it's used in manufacturing. Depreciation on the headquarters building two blocks away. Period cost because it's not manufacturing. The electricity bill depends entirely on usage. Factory electricity running the assembly line is product cost, but office electricity running computers in accounting is period cost. One company, one electric utility bill, two completely different classifications based on where the electrons go. Real world impact that shows why this matters. In 2020, during COVID lockdowns, this distinction literally determined which companies survived and which went bankrupt. Companies had to keep paying period costs, executive salaries, headquarters rent, insurance, debt interest, even with zero revenue. But product costs stopped when production stopped. Companies with high period costs relative to product costs suffered most. Airlines had massive period costs that couldn't be avoided. Plane leases cost billions, whether flying or parked. Airport gate leases continued. Pilot salaries period cost when not flying continued under union contracts. They lost $100 billion collectively. Meanwhile, Nike just stopped ordering from suppliers, eliminating most product costs immediately while cutting discretionary period costs like advertising. They actually turned a profit during lockdown quarters. This is why understanding the distinction between product and period costs literally meant survival versus bankruptcy during the pandemic and why CFOs who understood this distinction saved their companies while others failed. Let's do a rapidfire classification exercise using Starbucks, a company you all know intimately from your daily caffeine addiction. And this is exactly the format you'll see on your exam, except there you won't have my charming personality and terrible coffee puns to guide you through it. I'll name a cost, and you should immediately classify it as direct or indirect, product or period. And here's the key. Know why? Because on the exam, you'll need to justify your answer. And in job interviews, the reasoning matters more than the answer itself. coffee beans in your venty iced caramel macchiato. Direct material product cost. We can trace those specific Arabica beans from Guatemala to your drink. They become part of the physical product you consume and they're part of making the product. So, they go through inventory until the moment you buy that overpriced but delicious drink. Barista making your drink with a smile even though you ordered the most complicated modification possible. Direct labor product cost. We can trace their time to your specific drink. Starbucks actually times this at 87 seconds average for complex drinks. They're directly involved in production, transforming raw materials into finished product. Store manager salary, who's ensuring everything runs smoothly, indirect labor, and here's where it gets interesting. product cost if you view Starbucks as manufacturing beverages, which corporate does, but period cost if you view them as food service, which some accountants argue. This ambiguity is why context matters and why accounting isn't as black and white as people think. The rent for that prime corner location, Starbucks, pays $30,000 monthly for manufacturing overhead and product cost. If you consider the store a production facility, Starbucks view, but period cost if you see it as retail space. This is legitimately debated in accounting circles and shows why understanding the business model matters more than memorizing rules. Howard Schultz's $20 million compensation package when he was CEO. Indirect cost. Obviously can't trace it to your specific latte. Period cost. He's not involved in production. He's doing strategy and vision and completely irrelevant for pricing your drink, but very relevant for evaluating corporate efficiency. That Starbucks commercial with Taylor Swift you saw during the Super Bowl. Period. Cost all the way. Marketing expense that benefits all stores and products simultaneously. Expensed immediately. never included in the cost of any specific drink, even though it definitely drives sales. The electric bill for the store, this is where it gets complex, and where real accountants earn their salaries. Electricity for the espresso machines, blenders, and refrigerators holding milk is manufacturing overhead and product cost. But electricity for the seating area, lighting, Wi-Fi routters, and bathroom is period cost. Most companies use a reasonable allocation like 7030, but some track it precisely with separate meters, napkins, straws, and stirers. Usually treated as indirect materials and product cost because while technically traceable, one napkin per customer, the cost and effort of tracking would exceed the benefit. Plus, customers take varying amounts, so it's more practical to treat as overhead. This is called costbenefit analysis in accounting. Just because you can track something doesn't mean you should. Now we shift gears completely to understand cost behavior which is crucial for every single business decision from pricing to expansion and variable costs are the simplest to understand but most powerful for planning. Variable costs change in direct proportion to activity level. If activity doubles, variable cost doubles. If activity triples, variable cost triples. If activity drops to zero, like during a pandemic lockdown, variable cost drops to zero. These costs are perfectly predictable once you know the rate per unit, which makes them a manager's best friend for planning and a CFO's dream for forecasting. Think about your own variable costs that you deal with every day without realizing it. Every mile you drive, you burn gas. Perfect variable cost at about 15 cents per mile at current prices. Drive twice as far to visit home instead of staying on campus. Use twice the gas. Don't drive during winter break. Use no gas. Uber has built a $150 billion company on understanding variable costs perfectly. They pay drivers about 60 cents per mile plus 20 cents per minute. So a 10m 20inut ride costs them exactly $10 in driver payment. One ride equals $10. Thousand rides equals $10,000. Million rides equals $10 million. The total changes, but the rate per ride stays constant. Which is why Uber can price rides instantly anywhere in the world. They know their variable cost per mile and per minute down to the penny. add their margin and quote you a price before you even request the ride. Let me show you how Amazon thinks about variable costs with their mind-blowing logistics operation. Every package they ship has variable costs that they've optimized to an insane degree. Cardboard box, they have 127 different sizes to minimize. Waste cost 0.35 average. tape exactly 18 inches per package. Cost0.02 shipping label cost0.01 delivery driver payment averages $2.50 whether their own drivers or UPS fuel allocation about 30 cents per package based on route density. Total variable cost per package $3.18. Ship 100 million packages in a typical month. That's $318 million in variable costs. Ship $150 million during December holidays, $477 million. The beautiful simplicity is that Amazon knows if they can charge more than $3.18 per delivery, every additional package adds to profit. Which is why Prime membership is genius. You pay $139 annually thinking you're getting free shipping. But Amazon knows exactly how many packages the average Prime member orders, 50 per year, and prices it to ensure profitability. But here's the advanced insight that'll impress interviewers and separate you from other candidates. Smart companies are strategically converting variable costs to fixed costs when it makes sense, which is the opposite of what traditional textbooks teach. Amazon is building their own delivery network with branded vans and employed drivers. Fixed cost to replace UPS and FedEx payments variable cost. Why would they want fixed instead of variable? Because at massive volume, Amazon ships 7 billion packages annually, fixed costs become cheaper per unit. If you're shipping that many packages, owning the trucks is cheaper than paying per package. This is how modern tech companies think differently. They embrace fixed costs at scale while traditional companies fear them. Understanding when to prefer variable versus fixed costs based on volume and growth projections is what separates good managers from great strategists. Here's the beautiful paradox of variable costs that confuses students initially but becomes crystal clear once you see it. And it's absolutely critical for every business decision. Total variable costs change with activity. But variable cost per unit stays constant no matter the volume. It's like buying gas for your car. Whether you buy one gallon or 20 gallons, it's still $3.50 per gallon at the same station. The per unit consistency is what makes variable costs so useful for decisionmaking because you can predict total costs at any volume level instantly. Let's see this with Door Dash, a company that's revolutionized food delivery by understanding variable costs better than traditional restaurants. They pay drivers dashers in their terminology. $5 base payment per delivery plus 50 cents for insurance per delivery plus 30 cents for payment processing. That's $5.80 variable cost per delivery period. Deliver one order on a slow Tuesday afternoon, $5.80 total cost, $5.80 per unit. Deliver 100 orders during Friday dinner rush, $580 total cost, but still $5.80 per unit. Deliver 10,000 orders during Super Bowl Sunday, $58,000 total cost, yet still $5.80 per unit. Deliver 10 million orders per month across the country. $58 million total cost, but each individual delivery still costs exactly $5.80. 80s. This consistency means Door Dash knows exactly how much each additional order costs them regardless of volume, which is why they can make instant decisions about promotions, pricing, and market expansion. When they offer you free delivery, normally $3.99, they know they're losing $1.81 per order. $5.80 80 cost minus $3.99 they're not collecting. But they also know that promotion might get you hooked on the service and a regular customer orders 15 times per month with an average profit of $2 per order after the variable costs. The career application here is incredibly powerful and will put you ahead of 90% of business graduates. When you're analyzing any business, your first task is to identify the true variable cost per unit. Once you know this number, you can predict total costs at any volume level, calculate break even points, evaluate pricing strategies, and make expansion decisions. A former student now at McKenzie told me that literally 50% of her consulting work in the first year was just helping clients identify their true variable cost per unit because companies often think they know it, but they're including fixed costs by mistake or missing hidden variable costs. She charges clients $500 per hour. Well, McKenzie does. She gets paid $95,000 salary to do what you're learning right now for the cost of tuition. One project involved a meal kit company like Blue Apron that thought their variable cost per box was $15, but she discovered it was actually $23 when including customer acquisition cost, payment processing, and box returns. This revelation completely changed their pricing strategy and saved them from bankruptcy. Fixed costs are like your Netflix subscription or that gym membership you keep forgetting to cancel. The same cost whether you use it zero times or every single day. These costs remain constant in total regardless of activity level, at least within the relevant range. We'll get to that exception soon. But here's the twist that makes them tricky and why most businesses fail to understand their true impact. While total fixed cost stays the same, fixed cost per unit changes dramatically with volume. And this relationship drives every major business decision from pricing to expansion to survival during downturns. Let's make this real with your apartment rent, something every student understands painfully well. You pay $1,200 per month whether you're there every night studying or gone every weekend, visiting home, or partying at other schools. That's fixed in total. The landlord doesn't care if you're using the apartment. But think about the per night cost. Stay home all 30 nights in a month. That's $40 per night. Not bad compared to a hotel. only home 10 nights because of spring break, visiting family and staying at your significant other's place. Now it's $120 per night for your own apartment. Same $1,200 total, wildly different per unit costs. This is why hotels, airlines, and movie theaters are obsessed with capacity utilization. Their costs are mostly fixed. So, every additional customer is almost pure profit once they cover fixed costs. Tesla's Gigafactory in Nevada is the ultimate fixed cost example that shows both the opportunity and danger of high fixed costs. It cost $5 billion to build and costs $100 million monthly to operate regardless of production volume, security, basic maintenance, property taxes, skeleton crew of engineers, depreciation on equipment, minimum electricity to keep systems running. Produce 10,000 cars in a month. That's $10,000 of fixed cost per car just from the factory. produce 50,000 cars with the same facility. Now it's $2,000 per car, same $100 million total cost, but five times difference per unit. This is why Elon Musk tweets obsessively about production numbers and why he slept at the factory during production hell in 2018. Every additional car dramatically reduces per unit fixed costs. When Tesla was producing only 5,000 Model 3s per month in early 2018, they were losing money on every car despite selling them for $50,000 because the fixed costs per unit were astronomical. By late 2019, producing 35,000 per month, the same car became wildly profitable with no change in price or variable costs, just spreading fixed costs over more units. the strategic insight that'll make you valuable in any organization. High fixed costs create operating leverage, which is like financial steroids for profitability. If you can achieve high volume, you'll dominate competitors because your per unit costs plummet. Walmart used this strategy to destroy small retailers, massive fixed costs in distribution centers and technology, but spread over billions of items sold. But if volume drops, high fixed costs become a death trap. This is why capitalintensive businesses like airlines, hotels, and factories were devastated by COVID while variable cost businesses like consultants and software companies survived easily. When revenue stops, you can cut variable costs, but fixed costs continue relentlessly. When you understand this relationship between fixed cost and operating leverage, you understand why some businesses print money at scale while others die trying to get there. Not all fixed costs are created equal. And understanding the crucial difference between committed and discretionary fixed costs can literally save companies from bankruptcy. This distinction has determined which companies survived economic downturns and which became cautionary tales in business school cases. Committed fixed costs are long-term, cannot be significantly reduced in the short term, even if you wanted to, and usually relate to capacity. Think of them like your student loans. You're stuck with them regardless of circumstances until they're paid off or forgiven. These include building leases. You can't just break a 10-year lease without massive penalties. Equipment depreciation. That $10 million machine depreciates whether you use it or not. Property taxes. The government doesn't care if you're producing basic insurance. Try operating without liability insurance. And key management salaries. Firing your core team destroys institutional knowledge. Discretionary fixed costs on the other hand can be altered in the short term by management decisions. These are like your Netflix, Spotify, and gym subscriptions fixed while you have them, but you can cancel anytime without destroying your life. These include advertising, you can stop TV commercials tomorrow, research and development, painful but possible to pause, training programs, easy to cut but damages long-term capabilities. Travel and entertainment first thing cut in downturns and internship programs. Sorry, but you're usually first to go in cuts. During COVID, companies that understood this distinction survived while others died. Airlines like United had $2 billion monthly and committed fixed costs. Aircraft leases couldn't be broken. Airport gates were under long-term contracts. Union contracts required paying pilots even when grounded. They couldn't escape these even with zero flights. But they had $500 million in discretionary fixed costs. Advertising went to zero. Route development stopped. New uniforms canled. Training postponed. They cut every discretionary cost immediately while lobbying government for help with committed costs. Meanwhile, companies that treated all fixed costs as unchangeable, thinking we need to maintain our advertising presence, or we can't stop R&D, went bankrupt. Here's a real example that'll stick with you. General Motors in 2008 versus Tesla in 2020. GM treated their union contracts as committed. They were legally committed and couldn't cut labor costs during the financial crisis, leading to bankruptcy. Tesla treats almost all costs as discretionary. Elon famously said, "Every cost is variable if you're creative enough." During CO, Tesla cut salaries, suspended contractors, and reduced every possible cost while keeping production running. GM needed a government bailout. Tesla became the world's most valuable automaker. The lesson understanding which fixed costs you can control versus which control you is the difference between strategic flexibility and corporate death. The relevant range is where fixed costs reveal their dirty little secret. And it's one of the most practical concepts you'll ever use in business because it explains why growth isn't always good and why economies of scale eventually become dice economies of scale. Fixed costs are only fixed within a specific range of activity. beyond that range, they jump to a new level in what we call a step function. It's exactly like your unlimited data plan that isn't really unlimited unlimited until you hit 50 GB. Then they throttle your speed or charge you more. That 0 to 50 GB is your relevant range where the cost is truly fixed. Let me show you how Chipotle thinks about this with painful real world precision. One grill station with one employee can handle 100 burritos per hour. That's the setup in most Chipotle stores during normal times. The employee costs $15 per hour fixed for that hour regardless of how many burritos they make. And the grill has fixed costs of depreciation, maintenance, and energy. For 0 to 100 burritos in an hour, costs are fixed at $15 for labor plus $10 for equipment costs equals $25 total. But customer number 101 walks in during lunch rush. You need a second grill station and second employee. Fixed cost just jumped from $25 to $50 per hour. A 100% increase for one additional burrito. The relevant range was 0 to 100 burritos. This is why Chipotle managers obsess about staying within capacity during normal hours but fully staffing during predictable rushes. Crossing the relevant range doubles their labor cost. It's also why they'd rather have a slightly longer line than add another worker. They're managing to stay within the relevant range. Here's how this applies to your career and why every manager needs to understand it. Every business has multiple relevant ranges and knowing when you're approaching the edge is crucial for profitability. Amazon Web Services, the cloud computing giant that powers half the internet. Prices based on relevant ranges called tiers. Store zero to one tab of data, $23 per month, fixed in that range. Store one tab, you're in the next tier, $450 per month. That's right, one extra gigabyte just increased your cost by 2,000%. store 50 terabytes. New tier $8,000 per month. A startup using 0.99 tab pays $23, but at 1.01 tab pays $450. That extra 20 GB of data just cost them $427. This is why smart companies monitor their usage obsessively and architect their systems to stay just below tier boundaries. A former student working at a startup told me she saved her company $400,000 annually just by identifying they were 100 gigabytes over a tier boundary and implementing compression to get back under the interview insight that'll set you apart. When analyzing any business, always ask what's the relevant range and how close are we to the edge? A factory running at 70% capacity has room to grow with minimal additional fixed costs. Massive profit potential from volume growth. A factory at 95% capacity is about to hit a wall where expansion requires adding an entire new shift or building a new facility. Doubling fixed costs. Dangerous territory that requires careful planning. This single question has helped my students identify opportunities and risks that experienced analysts missed because they didn't think about relevant ranges. Mixed costs, also called semivariable costs, are everywhere in modern business, especially in the gig economy and subscription economy. Yet, most people don't recognize them, leading to terrible business decisions and missed opportunities. These costs have both fixed and variable components. They're like your cell phone plan with a base monthly charge plus overage fees or like a rental car with daily rate plus mileage charges. They start above zero even with no activity, the fixed component, and increase with activity, the variable component, making them tricky to analyze but critical to understand. Your utility bills are perfect examples that everyone deals with. Your electric bill has a basic service charge of maybe $20 per month. That's the fixed component you pay even if you're on vacation and use zero electricity just for being connected to the grid. Then you pay 12 cents per kilowatt hour used. That's the variable component. Use zero electricity during spring break. Still pay $20. Use 1,00 kilwatt hours running your gaming PC and air conditioning 247. Pay $20 plus 1,000 time 0.12 equals $140. The cost equation is y = a plus bx where y is total cost. A is the fixed component $20, b is the variable rate 0.12 and x is activity level kilowatt hours used. This formula will absolutely be on your exam and more importantly, you'll use it constantly in business. Let's look at how modern sales compensation works, which is almost always a mixed cost structure. A sales rep at Oracle selling enterprise software makes $60,000 base salary. Fixed component plus 5% commission on sales, variable component, sell nothing. Oracle still pays $60,000 because good salespeople won't work on pure commission. They have families, mortgages, and need income stability. Sell $1 million. Oracle pays $60,000 plus 0.05 * $1 million = $110,000. Sell $5 million. pay is $60,000 plus $250,000 equals $310,000. This mixed structure is brilliant because it provides income security while maintaining hunger for sales. Pure commission jobs are rare now because companies learned that desperate salespeople make bad decisions, oversell and damage the brand. Pure salary removes motivation. Mixed costs balance both needs. the practical application that'll make you valuable immediately. When analyzing costs, you need to separate the fixed and variable components to make good decisions. The high low method is the simplest technique. Take the highest and lowest activity levels from recent history. Find the cost difference, divide by activity difference to get the variable rate per unit, then solve for the fixed component. A student used this at her Goldman Sachs internship to analyze a client's cloud computing costs. The client thought their IT costs were purely variable based on usage, but she discovered a massive fixed component, minimum commitments, reserved instances, and support contracts. The company was paying $2 million monthly fixed plus 50 cents per transaction. They were making decisions assuming all costs were variable leading to underpricing of small customers who didn't generate enough transactions to cover the fixed component allocation. Her analysis led to minimum transaction requirements that save $2 million annually and she got a full-time offer before her internship ended. Let me show you a comprehensive comparison that'll lock in these cost behavior concepts forever and help you ace any exam question or interview case using a food truck business called Taco Paradise. That could be your side hustle after graduation. Imagine you're analyzing their three main cost categories. Tortillas, pure variable cost, truck lease, pure fixed cost, and manager compensation of salary plus commission mixed cost. At 1,000 tacos sold in a month, tortillas cost $500 total at 50 each. The truck lease is $2,000 for the month. And the manager costs $3,000 base salary plus $500 commission at 50 per taco for $3,500 total. Now double the volume to 2,000 tacos and watch what happens to per unit costs. This is where the magic of cost behavior becomes clear. Tortillas now cost $1,000 total, but still 50 each. Variable cost per unit stays constant, while total changes proportionally. The truck lease remains $2,000 total, but drops to $1 per taco. Fixed cost total stays constant while per unit plummets. Manager compensation becomes $3,000 plus $1,000 equals $4,000 total, which is $2 per taco. Mixed costs change in both total and per unit terms, but not proportionally. The total cost per taco dropped from $6 at 1,000 units. 500 + 2,000 + 3,500 equals $6,000 total to $3.50 at 2,000 units. 1,00 plus 2,000 plus 4,000, $7,000 total. Nearly half the cost per unit with only double the volume. This is why volume is everything in business with high fixed costs. That food truck's profit per taco went from negative to strongly positive just by doubling sales with no efficiency improvements, no supplier negotiations, no cost cutting, just spreading fixed costs over more units. This explains why group on deals work for restaurants. They'll accept customers at 50% off because their costs are mostly fixed. Rent, salaries, insurance. So, every additional customer above break even is almost pure contribution margin. It's why movie theaters don't care if you sneak into a second movie. Don't actually do this. The movie is playing anyway. The costs are fixed. Your marginal cost is nearly zero. It's why airlines will sell last minute tickets for $99 on a route that normally costs $500. Once the plane is flying, an empty seat generates zero revenue, but the costs are already committed. Understanding these relationships is what separates successful entrepreneurs from failed ones, good managers from great ones, and average students from those who get the job offers everyone wants. When making business decisions, we use a completely different framework for thinking about costs. And mastering these three concepts will make you better at decisions than most executives. There are three critical types of costs for decision-m. Differential costs, the difference between alternatives, the only costs that matter. Opportunity costs, what you give up by choosing one option, the invisible but critical costs, and sunk costs, already spent and gone forever, always irrelevant but psychologically powerful. Master these three, and you'll make better decisions than CEOs who confuse activity with progress and motion with direction. Differential costs, also called incremental or marginal costs, are the only costs that matter for decisions because they're the only ones that change based on what you choose. Should Starbucks add a new seasonal drink? Only look at differential revenues minus differential costs. The CEO salary, same either way. Ignore it completely. New ingredients like pumpkin spice, differential cost included. Additional barista training time, differential cost included. The rent, same whether they add the drink or not. Ignore it. This seems obvious, but companies mess this up constantly, including irrelevant costs that cloud decision-making. Blockbuster famously rejected buying Netflix for $50 million in 2000 because they included sunk costs from their existing store leases in their analysis. Those store costs were irrelevant. They'd pay them whether they bought Netflix or not. Only the differential impact mattered. $50 million to buy versus potential revenue and cost savings. Blockbuster went bankrupt with thousands of worthless stores. Netflix is worth $240 billion. That's a $240 billion mistake from including irrelevant cost in a decision. These three concepts will appear in every case study you do, every interview case you're given, every real business decision you'll ever make. A student just told me she got her Boston Consulting Group offer specifically because she correctly identified sunk costs in a case study while other candidates included them in their analysis. The case was about a pharmaceutical company deciding whether to continue developing a drug that had already cost $500 million. Other candidates said, "We've invested so much. We should continue." She said, "The $500 million is sunk and irrelevant. Only compare future cost to future revenues." The interviewer literally said, "Finally, someone who actually understands cost accounting." That could be you if you master these concepts. Differential costs and revenues are the heart and soul of every business decision. the alpha and omega of rational choice. Yet most people include irrelevant information that clouds their judgment. Differential amounts are simply the difference between any two alternatives, accept or reject the special order, make or buy the component, keep or drop the product line, expand or maintain capacity. Only differences matter. Everything that stays the same regardless of your choice is just noise that distracts from clear thinking. Let's say McDonald's gets a special order from a corporate event organizer. Supply 10,000 Big Macs at $3 each for a company picnic compared to the normal retail price of $5.50. The knee-jerk reaction is we'll lose $2.50 per burger. But that's completely wrong thinking. We need differential analysis. Differential revenue. 10,000* $3 equals $30,000 coming in. That wouldn't exist without this order. Differential costs. Ingredients: beef, buns, lettuce, sauce at $1.20 each equals $12,000. Special packaging for bulk order at 30 each equals $3,000. Overtime labor for rush production equals $2,000. Delivery to event location equals $1,000. Total differential cost $18,000. Differential profit $30,000US $18,000 equals $12,000. Accept the order. The manager salary, rent, regular staff wages, insurance, corporate overhead, all the same whether they accept or not. So completely irrelevant for this decision. But here's the advanced consideration that separates good analysis from great capacity constraints and opportunity costs. If McDonald's is at full capacity during lunch rush and accepting this order means turning away regular customers paying $5.50, then we have an opportunity cost. The opportunity cost is $2.50 per burger in loss profit from regular customers. $5.50 50 regular price minus $3 special price or $25,000 total for 10,000 burgers. Now the special order loses money. $12,000 differential profit minus $25,000 opportunity cost equals $13,000 loss. This is why restaurants charge more for catering than walk-in service. Their pricing and the opportunity cost of capacity. It's why consultants charge rush fees. Why Uber has surge pricing. Why airlines charge more for lastminute bookings when planes are nearly full. Real world example that made billions. Amazon Prime Day. Those massive discounts that seem crazy. Amazon's using differential cost analysis perfectly. The warehouses, website, and staff exist anyway. Those costs are committed and irrelevant for the decision. The differential cost of selling one more Echo Dot is just the unit cost, maybe $15, plus shipping $3. Everything else, warehouse rent, software engineers, Jeff Bezos's compensation stays the same. So selling an Echo Dot for $25, normally $50, still generates $7 differential profit. multiply by millions of units and Prime Day is pure profit despite the discounts. This is brilliant application of differential analysis that most retailers don't understand which is why Amazon dominates. Opportunity cost is the most important cost for decision-making. Yet, it never appears in any accounting system, never shows up on financial statements, and most managers ignore it completely, leading to catastrophically bad decisions that destroy billions in value. Opportunity cost is the benefit you give up by choosing one alternative over another. It's not what you pay, it's what you sacrifice, not what you spend, but what you forego. It's the road not taken, the date you didn't go on, the job you didn't accept, the investment you didn't make. Every single choice in life has an opportunity cost, including the choice to sit in this lecture instead of working a part-time job. That's costing you about $15 per hour in foregone wages. So, I better make this worth at least $22.50 for the 90minute class. Let me tell you about the most expensive opportunity cost in business history. A decision so bad it's taught in every strategy class as the ultimate cautionary tale. In 1999, Excite, then one of the biggest internet portals, could have bought Google for $750,000. The Excite CEO George Bell thought it was too expensive for a simple search engine and passed the opportunity cost of that decision. Google is now worth $2 trillion. That's a $2 trillion opportunity cost for a $750,000 decision. A return of 2,666,666%. George Bell could have been worth $500 billion today if Excite had maintained just 25% ownership through the IPO and growth. Instead, Excite went bankrupt, and Bell is teaching business school students about his mistake. On a smaller, but still massive scale, when Netflix was choosing how to spend $100 million in content budget in 2012, they could have bought sports rights like ESPN does, or they could produce original content. They chose to make House of Cards. The opportunity cost was the billions ESPN makes from live sports. But the benefit was launching Netflix's original content strategy that created $200 billion in market value. Here's how opportunity costs affect your life right now in ways you might not realize. You have $50,000 saved or borrowed for graduate school. Option A, get an MBA, which increases your starting salary by $30,000 annually, but costs two years of foregone wages, about $120,000 total, opportunity cost, plus tuition. Option B, invest the $50,000 in index funds, earning 10% annually, $5,000 per year, and keep working, gaining two years of experience and promotions. The opportunity cost of the MBA is both the $5,000 annual investment returns and the $120,000 in foregone wages. The opportunity cost of not getting the MBA is the $30,000 annual salary increment that compounds over your career. After running the numbers, MBA wins if you're under 30, but working wins if you're over 35 because you have fewer years to recoup the investment. This is exactly how every business decision should be analyzed. The key insight that'll make you invaluable. Opportunity costs are everywhere but invisible and most managers ignore them completely. When Amazon uses warehouse space for books with 20% margins, the opportunity cost is using that space for electronics with 35% margins. When Tesla uses battery cells for Model 3, the opportunity cost is using them for Model S with higher margins. When you choose an unpaid internship at Goldman Sachs, the opportunity cost is $15,000. From a paid internship at a smaller firm, always ask, "What's my next best alternative?" That's your true opportunity cost, and including it in decisions separates amateur hour from professional analysis. Sunk costs are amounts already spent that cannot be changed by any future decision. And here's the rule that will save you millions of dollars and years of wasted effort. Sunk costs are always irrelevant for decisions. Always, forever, no exceptions. No, but what if? No. In this special case, never. Yet, humans are psychologically programmed to consider sunk costs, creating the sunk cost fallacy, the most expensive cognitive bias in business that bankrupts companies, ruins careers, and destroys relationships. Master this concept, and you'll avoid mistakes that even brilliant people make constantly. your textbook that already cost you $300 that sunk whether you read it cover to cover or use it as a very expensive doors stop. The $300 shouldn't influence whether you study from it today. Only whether it's the best resource available should matter. Yet students think I paid $300 so I must use it even when better free resources exist online. That's the fallacy in action. letting past costs influence future decisions. The $300 is gone regardless. Only future benefits matter for rational decisionmaking. Let me tell you about the Concord supersonic jet. The most famous and expensive sunk cost fallacy in history, now taught in every business school as the Concord fallacy. Britain and France spent $15 billion in today's dollars developing the Concord in the 1960s. By 1970, they realized it would never be profitable, too expensive to operate. Too few routes where supersonic made sense. Environmental concerns about sonic booms. Any rational analysis said, "Stop now." But politicians said, "We've already invested so much. We can't stop now." They kept spending because of the sunk costs, eventually losing another 20 billion over 20 years of operation. Only 20 Concords were ever built. They never made a profit and the program was finally killed in 2003. The $15 billion already spent was sunk, irrelevant for the decision to continue. They should have only looked at future costs versus future revenues. This disaster is so famous that behavioral economists named the phenomenon after it. But here's the modern version that's even more dramatic. Quebe, the mobile streaming service founded by Hollywood legends Jeffrey Katzenberg and Meg Whitman. They raised $1.75 billion. launched in April 2020 with massive fanfare and shut down six months later in October 2020. After the first month, they had terrible user metrics. Only 1.5 million subscribers when they projected 7 million. The $ 1.75 billion was already sunk. But instead of cutting losses, they threw another $500 million at marketing, saying, "We've invested too much to quit now." Classic sunk cost fallacy. They should have asked, "Going forward, can we generate enough revenue to cover future costs?" The answer was clearly no, but the sunk costs clouded their judgment. Meanwhile, smart companies like Google are ruthless about ignoring sunk costs. They've killed over 200 products, including Google+, which they spent billions developing. When the data showed it wouldn't succeed, they killed it immediately, despite the billions already spent. That's why Google is worth $2 trillion, while Quebei is a business school case study in failure. The career lesson. In every job, you'll face situations where someone says, "We've already spent X, so we have to continue." That's your moment to shine by explaining that X is sunk and irrelevant. Only future costs and benefits matter. This single insight has gotten more of my students promoted than any other concept I teach. Now, let's examine how all these costs appear in financial statements. Starting with the traditional income statement format that every public company uses and that you'll see in every annual report and 10K filing. The traditional format, also called the functional format, groups costs by business function. Production costs, selling costs, and administrative costs. This is what the SEC requires for external reporting because it shows what the company spent money on, which investors want to know. It's like organizing your closet by clothing type. Shirts together, pants together, shoes together, logical for seeing what you own, but not helpful for putting together an outfit. Here's the traditional format structure. Start with sales revenue, what customers paid you. Subtract cost of goods sold, product costs that include direct materials, direct labor, and manufacturing overhead for units sold to get gross margin, also called gross profit. Then subtract operating expenses broken into selling expenses, getting and filling customer orders, and administrative expenses running the company to get net operating income. For example, Apple's 2023 income statement. Revenue $383 billion from selling iPhones, iPads, Macs, and services. Cost of goods sold $214 billion for components, assembly, and manufacturing overhead. Gross margin, $169 billion or 44%. This is why Apple is so profitable. 44% gross margin is incredible. Operating expenses $55 billion including retail stores, marketing, R&D, and corporate functions. Operating income $114 billion, 30% operating margin. Absolutely crushing it. Clean, simple, tells you Apple is insanely profitable. But here's what it doesn't tell you and why managers need something different. What happens if Apple sells one more iPhone? Which costs increase and which stay the same? If iPhone sales drop 10%, how much will profits decline? Should they accept a bulk order at a discount? The traditional format mixes variable and fixed costs within each category. COGS includes variable materials and fixed factory depreciation mixed together. Selling expenses include variable commissions and fixed advertising mixed together. You can't make decisions from this format because you don't know cost behavior, which is why internal managers need the contribution format instead. The traditional format is like knowing your car costs $5,000 per year, but not knowing how much is insurance fixed versus gas. Variable, fine for budgeting, but useless for deciding whether to drive to Florida for spring break. The contribution format income statement is managerial accounting's secret weapon. The X-ray vision that lets you see through the numbers to understand what really drives profitability. While the traditional format groups cost by function, production, selling, admin. The contribution format groups costs by behavior, variable versus fixed, revealing the contribution margin, the amount each unit contributes to covering fixed costs and generating profit. This format enables every important managerial decision from pricing to product mix to expansion and it's what every consulting firm builds first when analyzing a client. Here's the structure that changes everything. Sales revenue minus all variable costs, whether production, selling, or administrative, equals contribution margin, then minus all fixed costs, regardless of function, equals net operating income. Same numbers as traditional format, completely different insight. If Apple's iPhone has $400 variable cost, components, assembly, shipping, commissions, and sells for $1,000, the contribution margin is $600 per phone. Every additional iPhone contributes $600 toward covering Apple's massive fixed costs, stores, headquarters, R&D, and generating profit. Once fixed costs are covered, that $600 per phone is pure profit, which is why Apple's profits explode when iPhone sales surge. This format enables break even analysis that saves companies from disaster. Netflix uses contribution format internally to make every strategic decision. Each subscriber contributes about $8 per month after variable costs. Streaming bandwidth at 50, payment processing at 30, customer service allocation at $1.20. Fixed costs, content, technology overhead are $6 billion monthly. They need 750 million subscriber months to break even. $6 billion divided by 8 equals 750 million. With 250 million subscribers, that's 3 months to break even each year, then 9 months of profit. This is why Netflix can predict profitability so accurately, and why they know exactly how many subscribers they need in each country to justify local content investment. The career application that'll accelerate your rise. Every consulting firm McKenzie Bane BCG Deote uses contribution format for client analysis. When McKenzie gets a new client, the first thing they do is convert traditional financial statements to contribution format. One of my students at Bane said her entire first project was converting a retailer's reporting from traditional to contribution format. The client had been losing money for years without understanding why. The contribution format revealed they had excellent contribution margins, 35%, but excessive fixed costs, $50 million monthly for only $120 million in revenue. The solution was obvious once they could see it. They needed to either increase volume to spread fixed costs or dramatically reduce fixed costs. They chose to close underperforming stores, reducing fixed costs by $20 million, and invest in e-commerce, increasing volume with minimal fixed costs. The company returned to profitability within six months. That analysis earned the new analyst a $20,000 performance bonus on top of her $85,000 salary. This could be you. Let's integrate everything we've learned with one comprehensive example that shows how the same cost gets classified multiple ways depending on the decision context. Because this is what you'll actually do in your career. Look at the same numbers through different lenses for different purposes. Imagine you're analyzing costs for Sweet Green, the trendy salad chain that's expanding rapidly and just went public. Take their store manager salary, $60,000 per year, a pretty typical retail management salary. How many different ways can we classify this one cost? And why does each classification matter for different decisions? First, for cost assignment to products, it's indirect to any specific salad. You can't trace the manager salary to your particular kale Caesar salad, but it's direct to that specific store location. This matters for product pricing. Salary gets allocated across all salads versus store profitability analysis. Salary directly charged to that store. Second, for financial statements, this is where it gets controversial. It's a product cost if you view Sweet Green as manufacturing salads. They prep ingredients assembled to order, but it's a period cost if you view them as food service, like a restaurant. Sweet Green actually treats it as product cost in their internal reporting because they view themselves as manufacturing customized salads which lets them show better gross margins to investors. The industry context and business model determine the classification. Third, for cost behavior analysis, it's fixed to the store. same $60,000 salary whether they sell 100 or 1,000 salads daily. This matters for break even analysis and understanding operating leverage. If salad volume doubles, manager salary per salad halves improving profitability. Fourth, for decision-making contexts, if deciding whether to open a new location, it's a differential cost. New location needs new manager. If the manager is already hired for a committed lease period, it's sunk for closure decisions. If choosing between two manager candidates, only the salary difference is differential. If using the manager's time for catering versus instore, there's an opportunity cost. This multi-dimensional thinking is what separates great managers from average ones, and it's exactly how successful companies analyze costs. When Sweet Green went public in 2021, their S1 filing showed they think about costs exactly this way. They treat store labor as product cost. Unusual for restaurants because they view themselves as manufacturing salads, which lets them show 20% gross margins instead of the 15% they'd show if labor was period cost. This classification decision helped them raise $364 million in their IPO at a $2.9 billion valuation. Same costs, different classification, hundreds of millions in different valuation. The meta lesson here that'll guide your entire career. Cost accounting isn't about finding the right answer. It's about finding the useful answer for the decision at hand. The same cost that's irrelevant for one decision is critical for another. The same cost that's fixed for pricing decisions is variable for location decisions. Master this flexibility in thinking and you'll be invaluable in any organization. Companies don't need people who can mechanically classify costs according to rules. They need people who understand when each classification matters and why it affects decisions. That's what separates accountants from strategic thinkers. What separates $50,000 salaries from $150,000 salaries? What separates followers from leaders? Congratulations. You've just mastered cost concepts that most business professionals take years to truly understand, and some never do. Let's recap the six key learning objectives we've covered, each of which will appear in your exams, your job interviews, and your career decisions. First, you can now assign costs as direct or indirect depending on traceability to cost objects, understanding that the same cost can be direct to one object but indirect to another. Second, you know the three manufacturing cost categories. direct materials you can touch, direct labor that touches the product, and manufacturing overhead for everything else in the factory. Third, you understand that product costs flow through inventory on the balance sheet before becoming COGS while period costs are expensed immediately and this timing difference creates opportunities for profit management. Fourth, you can identify variable costs that change with activity, fixed costs that remain constant within relevant range, and mixed costs that have both components. Fifth, you know that differential and opportunity costs are relevant for decisions while sunk costs are always irrelevant no matter how much was spent or how recently. Sixth, you can prepare both traditional format income statements for external reporting and contribution format for internal decision-making. But here's what really matters for your career. How this knowledge transforms into job offers and promotions. Every one of these concepts appears in consulting case interviews at McKenzie, Bane, BCG, and Deote. When Oliver Wyman asks you to analyze a struggling retailer, you'll immediately identify their problem. High fixed costs relative to contribution margin. When PWC presents a special order decision, you'll focus on differential costs and ignore allocated overhead. When a startup asks if they should manufacture or outsource, you'll compare differential costs, including opportunity costs of capital and management attention. You're now equipped for these challenges with knowledge that others gain only through years of experience. Your homework is designed to reinforce these concepts through deliberate practice. Problem 1-23 walks through cost classifications for Tesla. Do this one first as it integrates everything we covered. Problem 1-35 involves a special order decision using differential analysis. This exact type appears on every exam and in actual business constantly. The Excel assignment has you build both income statement formats for the same company. This skill alone is worth $10,000 in consulting fees. And I mean that literally. Study tip. Form groups of three with each person teaching two learning objectives to the others. Teaching is the best way to learn. and explaining these concepts out loud will reveal gaps in understanding. Create flashcards for the classifications, but more importantly, find real companies you care about and classify their costs. It's more engaging to analyze Spotify or Nike than generic textbook companies. Next class, we'll apply these concepts to job order costing. How companies like Boeing track costs for custom products. How Tesla tracks cost for each car. How construction companies bid on projects. Bring your calculators in this chapter's knowledge because we'll build on everything we learned today. We'll see how these concepts become systems that track millions of transactions and drive billion-dollar decisions. Remember, you're not just learning accounting. You're developing a lens for understanding business that will serve you for decades. Every successful CEO from Warren Buffett to Elon Musk thinks in these cost concepts constantly. Buffett's famous investment decisions come from understanding fixed versus variable costs in different industries. Musk's push for manufacturing automation comes from understanding the relationship between direct labor and scalability. Now you have the same foundation they do. See you Thursday at 8:00 a.m. sharp. And remember, in the world of business, those who understand costs control the conversation, control the decisions, and ultimately control the outcomes. You're now one of those people. Use this power wisely and profitably.